7 Cheap Stocks, 1 Rich Trade

Right now, two factors are combining to produce opportunities for enormous gains on specific stocks. Below, you'll find a basket of seven stock option trades I put together to benefit from those circumstances, which has the potential to earn a 565% return. However, before we even begin thinking about earning fat returns, let's talk defense first, with a hedge idea to protect our existing assets.

Cheap volatility, expensive market: Buy puts!Despite the chilling effect of the market's recent losses, I still think complacency is too high right now, and that investors are underestimating -- and therefore, underpricing -- the potential for (downward) stock price volatility. The VIX (Wall Street's "fear gauge"), which measures the market's expectation for short-term volatility, closed just below 20 on Monday. That is higher than it has been in recent weeks, but it remains a bit below the index's historical average.

When volatility is cheap, so are options (in fact, the VIX is derived from option prices on S&P 500 futures). In that context, put options on the SPDR S&P 500 ETF expiring in January 2012 might be a reasonable choice to insure your portfolio against further declines. These options rise in value as the S&P 500 index declines. I expect the market to continue to trade in a range for an extended period of time (12 to 18 months or longer), and I think it likely that we will experience multiple corrections along the way.

Investors could set up a similar hedge with put options on the iShares Russell 2000 ETF -- small-cap stocks look even more expensive than the broad market (although you'd have to pay up for the options in volatility terms).

Cheap volatility, cheap stocks: Buy calls!While the broad market looks a bit pricey, that's not all the case for all stocks in the market. The table below describes a basket of call options on seven (mostly) high-quality stocks that look undervalued. The stocks are the product of a screen I created using Capital IQ; all have a forward price-to-earnings multiple in the bottom quintile of their industry and a trailing price-to-earnings multiple in the bottom quintile of its 10-year range (i.e., going back to June 2001).

The table's third column contains stock price targets for January 2013, which assume that the stocks' price-to-earnings multiples would get one-quarter of the way back to their 10-year average and that the companies achieve their consensus earnings estimate for 2012 (the latter may be a somewhat aggressive assumption). If the stocks do reach these price targets at option expiration, these are the returns investors would earn on the following option trades:

Source: Yahoo! Finance. Option return estimates are based on closing prices on June 13.

Profits ... and risksNo doubt about it, a 565% return looks very enticing, but let me be clear: This basket of options is a trade idea, not a recommendation. Although I suspect these stocks are undervalued, I haven't done the sort of due diligence that would enable me to determine it conclusively. Furthermore, this trade has a short time horizon -- that's right, even 18 months is the short term when it comes to stocks -- so identifying a catalyst for a revaluation in the share-price multiple would be very useful here. That would require detailed bottom-up research.

If you have the time and ability to do that type of research, you can compete for the sort of option returns I described above. If not, you can still put options to work for you by following the recommendations of Motley FoolOptions advisor Jeff Fischer. Of the 30 trades Jeff has completed to the end of May, 29 of them were closed at a profit, for an incredible 97% success rate.

Take the next step to earning these gainsIf you'd like to learn more about adding low-risk option strategies to your portfolio, give Jeff your email address in the box below and you'll receive -- at no cost or obligation to you -- the Options Insider playbook. You'll also get access to three videos in which Jeff discusses option strategies and an invitation to a live, interactive Q&A session in which Jeff and the entire Motley Fool Options team will be available to answer your questions. This should be an easy decision: What's the downside to learning about a new tool for your investor toolkit?

This article was originally published on Dec. 15, 2010. It has been updated.

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